Renminbi bulls should enjoy rally while it lasts

Cheerleaders for the renminbi shouldn’t yell themselves hoarse. The Chinese currency has risen unexpectedly against the dollar in the past few months thanks to a confluence of factors that will fade sooner or later. When they do, markets will revert to worrying about renminbi weakness and what it means for the global economy.

One of the main reasons for the currency’s rise is the vigour with which China has enforced capital controls. The campaign has reversed an exodus of capital that forced the People’s Bank of China, the central bank, to sell $1tn of foreign exchange reserves in 2014-15 to slow the currency’s decline.

Beijing has been pulling other administrative levers to bolster the renminbi. The PBoC granted itself more leeway to manipulate the currency by introducing a “countercyclical factor” to the already obscure formula it uses to set the renminbi’s central rate every morning.

The other main reason for the renminbi’s strength against the dollar is the weakness of the US currency. Donald Trump’s election initially boosted the dollar on expectations that tax cuts and extra infrastructure spending would breathe life into the US economy.

But the president’s failure to make any headway in Congress on his economic agenda caused the dollar to weaken. A strengthening euro, helped by a revival in eurozone growth and anticipation of tighter European Central Bank policy, further undercut the dollar’s appeal.

This was a double stroke of good luck for China. The combination of dollar weakness and euro strength has enabled Beijing to engineer a depreciation in the renminbi’s all-important trade-weighted exchange rate without a decline in the bilateral rate against the dollar — something that would doubtlessly have stoked Trump’s grievances against China.

So far this year, the renminbi’s nominal effective exchange rate declined by 2.2 per cent and the inflation-adjusted rate by 3.6 per cent, bringing the Chinese currency to within 5-10 per cent of fair value on our estimates. Along with the revival in global trade, this has spurred Chinese real exports, which have logged average annual growth of 8.7 per cent so far in 2017 compared with just 2.7 per cent in 2016.

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This fillip is of vital help in the economy’s painful transition from a reliance on investment and heavy industry to growth powered by consumption and services. So, ironically, the Trump presidency has been helping China, not hurting it as seemed likely given his threats to slap tariffs on Chinese exports.

President Xi Jinping, then, is probably pleased with the renminbi as he heads into next month’s five-yearly Communist party congress. The imperative in this important political year was to maintain stability, and for many both at home and abroad the dollar/renminbi rate remains a key measure of economic and financial stability.

But beneath the veneer of stability, all is not well. First, the official growth rate of 6.9 per cent in the first half of the year seems overstated. We estimate that the economy grew just 4 per cent.

Second, the capital controls that have buoyed the renminbi are a short-term boon but a long-term bane. China needs an open capital account as part of a strategy to allow markets to deploy capital more efficiently and to redistribute income from corporations towards households.

Third, by damming up China’s sea of money at home but not finding productive uses for it, policymakers risk causing more speculative asset price bubbles or sparking inflation.

So, as and when the dollar rebounds or internal pressures threaten to boil over, Beijing will find it hard to push on with the tough job of overhauling the economy without allowing the renminbi to fall.

China’s leadership will then have a choice: either allow much freer movement of capital, which would in the first instance cause the renminbi to weaken, or keep the controls and devalue.

By backing away from financial liberalisation now, China might be able to preserve the impression of swan-like calm for a bit longer. But there will be a price to pay: when the pressures now being bottled up are eventually released, the fallout will be magnified. Renminbi bulls should enjoy this year’s rally against the dollar while they can.

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